CHAPTER 38

Macro Policies in Developing Countries

Rise up, study the economic forces which oppress

you . . . They have emerged from the hand of
man just as the gods emerged from his brain.
You can control them.

— Paul LaFargue

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
 Macro Policies in
Developing Countries 38

Chapter Goals

• Examine some comparative statistics on rich and

poor countries
• Differentiate the normative goals of developing and
developed countries
• Discuss why economies at different stages in
development have different institutional needs
• Explain what is meant by the term dual economy

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 Macro Policies in
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Chapter Goals

• Distinguish between a regime change and a policy

change
• Explain why the central bank issuing too much money
is not a sufficient explanation of inflation for developing
countries
• Distinguish various types of convertibility
• Identify seven obstacles facing developing countries

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 Macro Policies in
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Developing Countries in Perspective

• 5 billion people live in developing countries
• Per capita income in developing countries is around $500
per year compared to $40,000 in the U.S.
• Americans who are classified as poor find it hard to
contemplate what life is really like in a truly poor country
• You can’t judge just an economy; you must judge the entire
culture
• Often economically poor societies have cultures that
provide individuals with a deep sense of fulfillment
and satisfaction

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Some Comparative Statistics
on Rich and Poor Nations
• The low average income in poor countries has its effects on
people’s lives, most people:
• Drink contaminated water
• Consume about half the minimum calories needed for
good health
• Do physical labor
• Have life expectancy of about 60 years
• Purchasing power parity (PPP) is a method of comparing
income by looking at the domestic purchasing power of
money in different countries

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 Macro Policies in
Developing Countries 38
Statistics on Selected Developing,
Middle-Income, and Developed Countries

GDP per Adult literacy Land and mobile

Country capita rate phones (per 1,000)
Developing
Bangladesh $470 43% 37
Ethiopia $220 43% 8
Middle-Income
Brazil $5,910 89% 587
Iran $3,470 77% 270
Developed
Japan $37,670 99% 1,176
United States $46,040 99% 1,223

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 Macro Policies in
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Growth versus Development

• Development refers to an increase in productive capacity
and output brought about by a change in a country’s
underlying institutions
• Development occurs through a change in the
production function

• Growth refers to an increase in output brought about by

an increase in inputs, given a production function

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 Macro Policies in
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Differences Between
Developed and Developing Economies
• Different weighting of normative goals due to differences
in wealth
• Developing countries face basic economic needs,
like adequate food, shelter, and clothing
• Differences in institutions
• Political differences and laissez-faire
• Dual economy
• Fiscal systems
• Financial institutions

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 Macro Policies in
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Differing Institutions
Political Differences and Laissez-Faire

• In many developing countries, institutional checks and

balances on government leaders often do not exist

• In these circumstances, economists who would favor an

activist macroeconomic policy in a developed country
might favor laissez-faire policies in developing countries

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 Macro Policies in
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Differing Institutions
The Dual Economy

• A developing country’s economy is usually a dual

economy

• Dual economy is the existence of two sectors:

• A traditional sector which does business in local
currency and produces in traditional ways
• An internationally oriented modern market sector
which is often indistinguishable from a Western
economy

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 Macro Policies in
Developing Countries 38

Differing Institutions
Fiscal Structure of Developing Economies

• Discretionary fiscal policy is almost impossible for

developing economies

• They don’t have the institutional structure necessary

to levy and collect taxes

• Many government expenditures are mandated by

political considerations

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 Macro Policies in
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Differing Institutions
Fiscal Structure of Developing Economies

• Developing countries may experience a regime change,

which is a change in the entire atmosphere within which
the government and the economy interrelate

• A policy change is a change in one aspect of

government’s actions, such as monetary or fiscal policy

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 Macro Policies in
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Differing Institutions
Financial Institutions of Developing Economies
• Financial institutions in developing countries are different
from those in developed countries because of the dual
economy in developing countries
• In the traditional economy the financial sector is
unsophisticated, with some trades made by barter
• In the international economy, the financial sector may be
very advanced
• Some of the limitations of the traditional economy are
overcome with micro credit programs on the Internet

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 Macro Policies in
Developing Countries 38

Monetary Policy in Developing Countries

• The primary goal of central banks in developing countries

is to keep the economy running

• Central banks in developing countries are generally less

independent than ones in developed countries

• Buying and selling foreign currencies in order to stabilize

the exchange rate is an important function

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 Macro Policies in
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Various Types of Convertibility

• Full convertibility is when individuals may change their
currency into any currency they want for whatever legal
purpose they want

• Convertibility on the current account is a system that

allows people to exchange currencies freely to buy goods
and services, but not assets in other countries

• Limited capital account convertibility is a system that

allows full current account convertibility and partial capital
account convertibility

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 Macro Policies in
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Various Types of Convertibility

• Because almost no developing country has full

convertibility, the international part of the dual economy
is dollarized

• Dollarized contracts are framed in, and accounting is

handled in, dollars, not in the home country’s currency

• Nonconvertibility does not halt international trade; it

merely makes it more difficult

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 Macro Policies in
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Various Types of Convertibility

• Exchange rate policy is an important central bank function

when the developing country has partially convertible
exchange rates

• Trade in the currency is thin because there are not

many buyers and sellers

• Exchange rate policy is buying and selling foreign currencies

in order to stabilize the exchange rate

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 Macro Policies in
Developing Countries 38
Conditionality and
Balance of Payments Constraints

• Developing countries often rely on advice from the

International Monetary Fund (IMF)

• The IMF is a major source of temporary loans to stabilize

their currencies

• The basis for most IMF loans is conditionality which is

the making of loans that are subject to specific conditions,
usually that deficits be lowered and money supply growth
be limited

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 Macro Policies in
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Obstacles to Economic Development

Seven problems facing developing countries are:

1. Political instability
2. Corruption
3. Lack of appropriate institutions
4. Lack of investment
5. Inappropriate education
6. Overpopulation
7. Health and disease

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 Macro Policies in
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Political Instability

• Political instability closes off external and internal sources

of financial investment

• Foreign companies and wealthy citizens are reluctant to

invest when the government is unstable creating a high
risk of loss

• An unequal distribution of income contributes to the

instability because economic prospects are so bleak that
many people are willing to support or join a guerilla
insurgency

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 Macro Policies in
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Corruption

• Developing countries often lack a well-developed

institutional setting and public morality that condemns
corruption

• As a result, bribery, graft, and corruption are ways of life

in most developing countries

• Knowing that bribes must be paid prevents many people

from doing things that would lead to growth

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 Macro Policies in
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Lack of Appropriate Institutions

• Markets require the establishment of property rights,

which is a difficult political process

• The existence of markets is meshed with the cultural

and social fabric of society

• Some of the cultural and social institutions in developing

countries may not be conducive to growth

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 Macro Policies in
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Lack of Investment
• Savings for investment can be generated internally or
brought in from outside the country
• With very low per capita income, people in developing
countries aren’t able to save
• Savings from abroad is in the form of private investment
or aid from foreign governments
• Foreign aid are funds that developed countries lend or
give to developing countries
• Foreign aid amounts to about $14 per person in
developing countries

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 Macro Policies in
Developing Countries 38

Lack of Investment
• Foreign businesses have a greater incentive to invest
in a country if that country has:
• A motivated, cheap workforce
• A stable government supportive of business
• Sufficient infrastructure investment
• Raw materials that can be developed
• Developing countries that have been successful in
attracting investment often get further investment
• Economic takeoff is a stage when the development
process becomes self-sustaining

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 Macro Policies in
Developing Countries 38

Inappropriate Education
• The right education is a necessary component for growth
• Often educational systems in developing countries
resemble Western educational systems and may be
irrelevant to growth
• Basic skills like reading, writing, and arithmetic, are likely
to be more conducive to economic growth in developing
countries
• Developing countries often experience a brain drain
which is the outflow of the best and brightest students from
developing countries to developed countries

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 Macro Policies in
Developing Countries 38

Overpopulation
• Thomas Malthus predicted that population would outrun
the means of subsistence
• Malthus’ prediction has been avoided in developed
countries
• Many developing economies have not avoided the
Malthusian fate because diminishing marginal productivity
has exceeded technological change
• Some developing nations have tried to limit population
growth by various means, from advertising campaigns to
forced sterilization

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 Macro Policies in
Developing Countries 38

Health and Disease

• A country must have a reasonably healthy population in
order to develop economically

• Some diseases, such as HIV/AIDS and tuberculosis,

make it difficult to work and take care of children

• Drug companies have very little incentive to work on

developing low-cost medicines to treat diseases in
developing countries because the people are poor and
can’t pay for the drugs

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 Macro Policies in
Developing Countries 38

Chapter Summary
• While policies in developed countries focus on stability,
developing countries struggle to provide basic needs
• Development is an increase in productive capacity and
output brought about by a change in underlying institutions
• Many developing economies have serious political
problems that make it impossible for government to take
an active, positive role in the economy
• Many developing countries have dual economies, one a
traditional, nonmarket economy, and the other an
internationalized market economy

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 Macro Policies in
Developing Countries 38

Chapter Summary
• Rather than policy changes, most developing countries
need regime changes – changes in the entire atmosphere
within which the government and the economy relate
• Although developing countries know that printing too much
money leads to inflation, their choices are limited
• Some central banks lack independence and for others the
only alternative is the collapse of government
• Most monetary policies in developing countries focus on
the international sector and are continually dealing with the
balance of payments constraint

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 Macro Policies in
Developing Countries 38

Chapter Summary

• Most developing countries have some type of limited

convertibility to limit the outflow of saving
• Macro policies in developing countries are more concerned
with institutional policies and regime changes than are
macro policies in developed countries
• Seven obstacles to economic development are political
instability, corruption, lack of appropriate institutions, lack of
investment, inappropriate education, overpopulation, and
poor health and disease

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